Summary: The Euro-crisis began in March 2010, and yet its causes and basic elements remain widely misunderstood — including, based on their public statements, by many of Europe’s leaders. Here Prof Pettis gives a clear explanation of what’s happening, and of Spain’s only three ways out of this crisis.
Excerpt from “Three cheers for the new data?”
By Michael Pettis (Prof of Finance, Peking University)
November 12, 2012
Republished with his general permission.
Spain’s three options
Finally, and to turn away from China, we seem to be experiencing a renewed period of increased optimism over European prospects, but we should refrain from joining in. The optimism will soon fade. In the great debate over the economies of countries like Spain, we sometimes forget the simple arithmetic of economic rebalancing. This arithmetic, like it or not, severely limits the options open to these countries.
For many years, thanks partly to bad policies in Spain but mainly to aggressive attempts by Germany to achieve growth by forcing a trade surplus onto its European neighbors, Spain, and many other countries in Europe, ran enormous trade deficits. It is easy and popular to blame the greed of the Spanish and the stupidity of the government for the mess in which Spain has found itself, but the policies Germany put into place in the late 1990s guaranteed that Germany, a country that had run massive trade deficits in the 1990s, would run equally massive trade surpluses in the subsequent decade.
Because once they joined the euro the rest of Europe had no control over the value of their currencies and the level of their interest rates, it was inevitable that European countries that had joined the euro with higher-than-average levels of inflation would be forced to respond to German trade surpluses either by forcing up unemployment or by forcing up consumption, and so running the large trade deficits that corresponded to Germany’s trade surplus. No other choice was possible.
These deficits as a matter of economic necessity had to be financed with loans from Germany, leaving Spain with an enormous debt burden. Just as Spain could not run a trade deficit without borrowing from abroad, Spain can only repay its debt if runs a trade surplus. What is more, since rich Spaniards are taking enormous amounts of money out of the country in order to protect themselves from the debt crisis they know is coming, the Spanish trade surplus must be large enough to accommodate both flight capital and debt repayments.
In practice there are only three ways Spain can achieve a sufficiently large trade surplus.
The first way
The first way requires that Berlin reverse those policies that forced a German trade surplus at the expense of its European neighbors. Berlin must cut taxes and increase spending so much that Germany runs a trade deficit large enough to allow Spain to run the opposite surplus, which it must do if it hopes to repay the debt.
This, by the way, is exactly what John Maynard Keynes demanded that the US do in the late 1920s if it wanted to avoid a global crisis. The US ignored Keynes, and the crisis occurred just as he predicted. Germany, with the same uncomprehending stubbornness today that the United States displayed in the 1920s, refuses to do what is necessary to prevent a crisis.
But, and this is the key point, if Germany does not move quickly to reverse its trade surplus, Spain only has two other ways of creating a trade surplus in spite of German recalcitrance.
The second way
One way requires that Spanish wages are forced down by many years of high unemployment. This will allow Spain to run a sufficiently large trade surplus.
Part of the reason Spain can then run a trade surplus is that as wages drop relative to those of Germany, Spanish goods will become more competitive in the international markets, but the real reason why Spain will run a trade surplus after many years of unemployment is that Spanish workers will simply be unable to afford to buy much.
The third way
Spain’s second option is to leave the euro and devalue. This will immediately force down prices and wages relative to Germany.
Neither option will be easy, but it is important that we realize that if Germany doesn’t adjust, Madrid has no choice but to pick one or the other. Both options will cause debt to soar in real terms, and will probably force Spanish businesses, and even the government, into default, but in both cases Spain will begin running large trade surpluses.
As much as leaders in Madrid, Brussels and Berlin hate to admit it, these are the only three options open to Spain. Any policy proposed by policymakers that is not consistent with one of these three ways will be impossible to achieve.
The path they’ve chosen
For now, Spain has implicitly chosen the option of unemployment, in the hopes that it will be able to adjust in one or two years and eventually resume normalcy. No country, after all, can bear the pain that Spain is bearing today without a serious deterioration in the social and political fabric.
But both history and common sense teach us that the idea that after one or two more years of adjustment Spain will have resolved its debt problems and can bring unemployment down is nonsense. It is going to take much longer than that. If Spain wants to continue along its current path, it must be prepared to suffer at least another five years of extraordinarily high unemployment, an erosion of the productive capabilities of its economy, and rising political chaos.
Or it can leave the euro. Given how rapidly the political environment is deteriorating, I have little doubt it will leave the euro. Unfortunately we will have to wait a few more years for Madrid to drive the economy into the ground and to rip apart the country’s social fabric before they choose to devalue. But I fully expect they eventually will.
About the Author
Michael Pettis is a Senior Associate at the Carnegie Endowment for International Peace and a finance professor at Peking University, where he specializes in Chinese financial markets. He is also Chief Strategist at Guosen Securities (HK), a Shenzhen-based investment bank.
Pettis has worked on Wall Street in trading, capital markets, and corporate finance since 1987, when he joined the Sovereign Debt trading team at Manufacturers Hanover (now JP Morgan). Most recently, from 1996 to 2001, Pettis worked at Bear Stearns, where he was Managing Director-Principal heading the Latin American Capital Markets and the Liability Management groups. He has also worked as a partner in a merchant banking boutique that specialized in securitizing Latin American assets and at Credit Suisse First Boston, where he headed the emerging markets trading team.
Besides trading and capital markets, Pettis has been involved in sovereign advisory work, including for the Mexican government on the privatization of its banking system, the Republic of Macedonia on the restructuring of its international bank debt, and the South Korean Ministry of Finance on the restructuring of the country’s commercial bank debt.
For More Information
For all posts about the Euro-crisis see Europe – on the road to division or unification.
Other posts about Spain:
- Written one month before the crisis began: The periphery of Europe – a flashpoint to the global economy, 8 February 2010
- Are Europe’s rulers copying the policies of Herbert Hoover in 1929, or the French Monarchy in 1789?, 26 January 2012
- The Fate of Europe has become visible. Only how and when the break comes remains uncertain., 6 June 2012
- The bailout of Spain’s banks shows the heart of our problem, 12 June 2012